Taxation of Limited Liability
Companies and Pass-through Entities Compared to "C" Corporations
1.
Liability
Protection. "C"
Corporations and Limited Liability Companies provide similar protection
of the personal assets of the shareholder/members.
2.
"C" Corporations Are Not a Pass-Through Entity. Whereas, Limited Liability Companies are generally
a pass-through entity and treated as a partnership for tax purposes.
3.
Double Taxation. The
"C" Corporation is subject to double taxation at both the corporate
level and upon distribution to shareholders. A Limited Liability
Company treated as a partnership has one level of taxation.
4.
Phantom Income. "C"
Corporations can accumulate earnings paying tax at the corporate level
without the shareholders being individually taxed. The LLC, on the
other hand, if it attempts to accumulate earnings, could make the
shareholders subject to "phantom" income, therefore being taxed on
income not earned. The "phantom income" issue is a simple concept.
"Phantom income" arises where the shareholder has income for tax
purposes and no money received from the LLC to pay for those taxes. If
the Limited Liability Company earns income and then uses that income to
purchase a capital good, the result is phantom income to the members.
For example, if the LLC earns $100,000, and purchases a machine for
$100,000, in the same year, the LLC has no income to distribute to the
members. Nevertheless, the individual members are taxed on that
$100,000 (minus the depreciation pass-through to the members) without
receiving any money to pay those taxes. Other examples include where
one group of members lends money to the LLC and then expects to be paid
back at a rapid rate. The amount of money paid back to the member,
which constitutes loan principal, is not deducted by the LLC and is
subject to income tax for the members.
5.
Retirement Plan Differences. LLC
members who are treated as partners and own more than 10% membership
interest cannot borrow against a qualified retirement plan account
pursuant to IRC Section 4975. (This is similar to the "S" Corporation
Shareholder who owns more than 5% of the corporation who is also
prevented from borrowing against the qualified retirement plan
account.) On the other hand, the "C" Corporation Shareholder/Employee
can borrow against their qualified retirement plan.
6.
Limited Number of Members. LLCs,
although legally not limited to a particular number of members, are
practically limited by Internal Revenue Code. IRC 7704 provides that if
LLC membership interests are "widely held", they are treated as
"publicly traded." If the LLC is considered "publicly traded", then the
LLC will be treated as a "C" Corporation for Federal Income Tax
purposes.